EIU Global Forecasting Service

NAFTA: what if it falls apart?

January 29th 2018The Canadian prime minister, Justin Trudeau, says that he still believes that Canada, Mexico and the US can renegotiate the North American Free-Trade Agreement (NAFTA) to benefit all three countries. His comments, made as negotiators prepare to reconvene in Montreal on January 23rd, are based on his belief that the deal has been good for the NAFTA partners. This view is not shared by the US president, Donald Trump, who continues to threaten to pull the US out. The Economist Intelligence Unit's baseline view remains that renegotiation talks will end in agreement later in 2018. However, we have also produced a rough forecast of the chain of events that would follow if Mr Trump triggered withdrawal. Even if he was to do so, the president would have to overcome a challenging set of obstacles if the US was to divest itself of regional free trade entirely.

Through Robert Lighthizer, the US trade representative, Mr Trump has adopted a hardline stance on NAFTA. He has insisted upon major changes, including scrapping a dispute-settlement mechanism, setting automotive content rules to disproportionately benefit the US, inserting a five‑year sunset clause on the agreement, requiring dollar-for-dollar reciprocity on government procurement, and opening up the Canadian dairy market to US imports. This strategy is designed to push Canada and Mexico to agree to bigger concessions than they might otherwise have done if the US's initial demands had been less extreme. And if Canada and Mexico reject the terms as unworkable, the US negotiating team could walk away, blaming their partners' unwillingness to compromise.

With five rounds of negotiation finished and a sixth to start imminently, there is still no final agreement in sight, although progress has been made on multiple areas, such as digital trade and regulatory practices. Mr Trump continues to shift direction as frequently as the wind. Speculation again rose that he was leaning towards abrogation in January, but he then told farmers in Tennessee that he was "working very hard to get a better deal". Meanwhile, Chrystia Freeland, Canada's foreign minister, announced that her team had done some "creative thinking" on how US demands on the automotive sector could be met. But at the same time as Canada extended this carrot, it wielded a stick by launching a broad trade complaint against the US at the World Trade Organisation (WTO). Canada's trade minister, François-Philippe Champagne, said that the move was meant to show strength and gain respect. Mr Lighthizer was highly critical.

Reaction begins in the currency markets

The exchange of barbs may be posturing, but we also take the possibility of a US withdrawal seriously. Consequently, we have established a basic forecast for the chain of events that could follow if Mr Trump decided that the negotiations had failed. First, he would need to trigger Article 2205, a formal notification that would take the US out of the agreement in six months' time. The most immediate effect would be in the currency markets, where the Canadian dollar and the Mexican peso would lose value against the US dollar. In turn, the US dollar would weaken against the other two safe-haven currencies, the euro and the yen. In both cases the currencies would fall substantially in the first couple of days, before rebounding as more details about the withdrawal were provided. These are fairly safe assumptions: the Canadian dollar and the peso have weakened whenever sentiment around the negotiations has soured. Freely floating currencies are designed to be economic stabilisers against economic shocks. For example, a weaker Canadian dollar or Mexican peso owing to the collapse of NAFTA should, in theory at least, make Canadian goods more competitive abroad.

In the US, triggering Article 2205 would also prompt a major showdown with Congress. There is no consensus in the US over whether the president can abrogate a treaty on his own. On the one hand, trade agreements such as NAFTA are merely deals that only become law once Congress has passed the enabling legislation, and the Constitution grants Congress the authority to regulate foreign trade. On the other hand, presidents have in the past withdrawn from international trade agreements without congressional approval; Franklin Roosevelt did it several times in the 1930s.

Yet, given that much of the Republican congressional leadership remains staunchly in favour of free trade and that even those Democrats that oppose NAFTA would be unwilling to give Mr Trump an easy win, we expect fierce resistance to any withdrawal attempt. We expect that Congress would insist on the enabling legislation being maintained. This would keep NAFTA running in the same manner as during the notice period. If it wished to escalate tension with the White House further, Congress could also threaten to refuse to pass other legislation or to approve presidential appointments.

Fight or flight?

At this point, the timeline becomes crucial. Mexico will hold presidential and legislative elections on July 1st. Even if Mr Trump was to trigger Article 2205 next month, withdrawal would not be completed until after the Mexican election. The Mexican negotiating team has been clear from the beginning that if the US walked away, it would too. However, we also note that the elections will produce a new president (the incumbent, Enrique Peña Nieto, is ineligible to run again) and a new government with a clean slate. Talks could in theory be restarted without any accusations of weakness or hypocrisy. However, given our baseline assumption that the most likely winner of Mexico's presidential election will be the leftist frontrunner, Andrés Manuel López Obrador, who has tended to favour more nationalist rhetoric than his rivals, restarted negotiations under his leadership would be likely to be more problematic, rather than less so. In the event of a collapse of NAFTA, and rather than take up the talks again, Mexico would be likely to revert to WTO tariffs and rules on trade.

We expect Canada to take the opposite approach; the Trudeau government has been very clear in its commitment to free trade, and it is highly unlikely that it would be content to revert to WTO rules with its largest trading partner without exhausting every possible option. Another consideration is whether a US withdrawal would also remove the Canadian-US Free-Trade Agreement (CUSFTA), the bilateral precursor to NAFTA. If CUSFTA remains in place, so too would tariff-free trade in the areas covered by NAFTA. Canada's preference in the event of a US withdrawal would be to keep CUSFTA alive and use this as the basis for further talks.

However, our central forecast remains that negotiations will conclude with a revised agreement. This is for four reasons. First, all sides have a firm, economic incentive to keep NAFTA going. Some of Mr Trump's advisors have framed this for him in terms of maintaining the stockmarket's excellent performance, a metric of which the president is disproportionately proud. Second, the administration would be subject to such an enormous national and international lobbying effort that it would take great expenditure of political capital to overcome. Third, the threat of fierce congressional opposition would make withdrawal less attractive. Fourth, some members of the Trump administration appear to understand that many of the biggest supporters of NAFTA in the US are farm and automotive workers, who are also an important part of Mr Trump's supporter base. Finally, the Canadian delegation has begun to hint at the flexibility required to move towards some of the US's demands. A combination of these reasons ought to be enough to keep the negotiations on the rails.